Two recent tax cases highlight the challenges taxpayers may face when attempting to use the real estate professional exception to the passive loss rules to deduct rental losses. In one, the Ninth Circuit affirmed a district court and held that Code Sec. 469(c)(7) does not automatically render a real estate professional's rental losses nonpassive and deductible where the taxpayer did not materially participate in the real estate endeavors. In the other, the Tax Court found that, because of her credible testimony and the substantial amount of money and time devoted to each rental property, a taxpayer met the material participation requirements in Reg. Sec. 1.469-5T(a)(7) and could deduct her rental losses. Gragg v. U.S., 2016 PTC 288 (9th Cir. 2016); Hailstock v. Comm'r, T.C. Memo. 2016-146.

Due to depreciation, rental activities often generate net losses. Under Code Sec. 469(c), these losses are subject to the passive activity loss (PAL) limitation rules and are usually deductible only against passive income. While rental losses are per se passive losses, Code Sec. 469(c)(7) carves out an exception for taxpayers in the real property business. Often, taxpayers argue that they are real estate professionals and are entitled to rental loss deductions under the special rules in Code Sec. 469(c)(7).

Passive Activity Loss Limitation Rules

In general, Code Sec. 469 disallows passive activity losses. Code Sec. 469(c)(1) defines a passive activity as any activity involving a trade or business in which the taxpayer does not materially participate. Under Code Sec. 469(c)(2), rental activities are per se passive activities.

Code Sec. 469(c)(7) provides an exception to the rule in Code Sec. 469(c)(2), however, for taxpayers in real property businesses. Under that exception, Code Sec. 469(c)(2) does not apply to any rental real estate activity if more than one-half of the personal services performed in trades or businesses by the taxpayer during the tax year are performed in real property trades or businesses in which the taxpayer materially participates, and the taxpayer performs more than 750 hours of services during the tax year in real property trades or businesses in which the taxpayer materially participates. In the case of a joint return, these requirements are satisfied if and only if either spouse separately satisfies such requirements. Generally, each interest of the taxpayer in rental real estate is treated as a separate activity unless the taxpayer makes an election under Code Sec. 469(c)(7)(A) to treat all interests in rental real estate as one activity.

Code Sec. 469(h) provides that a taxpayer is treated as materially participating in an activity only if the taxpayer is involved in the operations of the activity on a basis which is regular, continuous, and substantial.

Gragg v. U.S.

In 2006 and 2007, Delores Gragg worked as a licensed real estate agent for a real estate brokerage firm. During those year, Delores and her husband owned two real estate rental properties. The Graggs' rental properties incurred losses and, on joint returns for 2006 and 2007, the couple deducted those losses from their taxable income. The IRS disallowed the losses on the basis that, because the Graggs did not materially participate in the rental properties, the losses were passive activity losses that could only offset passive activity income. The couple took their case to a district court, arguing that Delores's full-time occupation as a real estate professional generally relieved her and her husband from having to show material participation in their rental real estate activities before deducting losses from those activities against their income.

The key question for the district court was whether, under Code Sec. 469(c) and related regulations, the Graggs had to establish their material participation in their rental real estate activities separate and apart from Mrs. Gragg's undisputed material participation in her profession as a real estate agent. The district court concluded that they did have to establish material participation and, because they had not proven they materially participated in their rental activities, the court disallowed their rental loss deductions.

The Ninth Circuit agreed with the IRS, saying that the text of the statute did not support the Gragg's interpretation. The effect of the Code Sec. 469(c)(7) exception, the court said, is merely that the per se bar in Code Sec. 469(c)(2) does not apply. If the per se rental bar does not apply, the court concluded, then the general Code Sec. 469(c)(1) rule does apply and a rental activity is passive unless the taxpayer materially participates. Further, the court stated, regulations implementing Code Sec. 469 reinforce this interpretation. Reg. Sec. 1.469-9(c)(1), the court noted, provides that a taxpayer who qualifies as a real estate professional can treat rental losses as nonpassive, but only so long as the taxpayer materially participates. That regulation, the court said, does not conform with the Graggs' understanding that the Code Sec. 469(c)(7) exception excuses real estate professionals from the material participation requirement.

Hailstock v. Comm'r

Sometime in 2004, Beth Hailstock left her government job and went into the real estate business full-time. Between 2003 and 2008, Hailstock purchased numerous properties using an inheritance, savings, two lines of credit, and credit cards. She rented and incurred expenses in relation to some of the properties; she sold some of the properties within one year of acquisition (without renting); and she held some of the properties for investment (without renting).

From 2005 to 2009, Hailstock devoted substantial time and effort to her real estate endeavors and did not work elsewhere. She spent well over 40 hours per week carrying on her real estate business. Hailstock's duties included checking messages for work orders, purchasing materials and cleaning supplies, supervising workers doing rehabilitation work, meeting with and conducting background checks on prospective tenants, executing leases, handling complaints regarding existing tenants, searching for new properties to purchase, taking real estate classes, and collecting rent payments from tenants.

In October of 2011, the IRS received from Hailstock a Form 1040 for each of the tax years 2005, 2006, 2007, 2008, and 2009. On each return, Hailstock listed her occupation as "Real Estate Professional." She reported all of her real estate activities (i.e., renting, investing, and selling) on Schedules C, Profit or Loss From Business. The IRS audited her 2005-2009 tax returns and, in the course of the audit, Hailstock provided the IRS with reconstructed Forms 1040 for 2005-2009. Attached to the reconstructed returns were Schedules E, which reported rents and expenses pertaining to Hailstock's rental properties.

The IRS used documents and records obtained from various financial institutions to perform a bank deposits analysis for Hailstock and determined Hailstock's income for 2005-2009. The IRS's bank deposits analysis discovered large discrepancies between the amounts deposited into Hailstock's bank accounts and the amounts of rental income that she reported on Schedules E of her reconstructed returns. The IRS issued Hailstock notices of deficiencies for 2005-2009. Among other things, the IRS concluded that Hailstock had unreported rental income and that some of her rental losses were not deductible.

At trial, after Hailstock offered explanations for specific unidentified deposits in the IRS's bank deposits analysis, the court found that Hailstock had unreported rental income in an amount less than that determined by the IRS. With respect to whether Hailstock could deduct all her rental losses, the court first looked to whether Hailstock's losses were limited by the passive activity loss rules. The court had to determine if Hailstock materially participated in her real property trades or businesses. In assessing material participation, the court rejected Hailstock's assertion that she made the election in Code Sec. 469(c)(7)(A) to treat all her real estate activities as one activity, saying that a taxpayer's intention of aggregating properties without a proper election is insufficient. The court noted that there must have been an affirmative declaration by the Hailstock and there was not. Simply listing multiple properties on a Schedule E is insufficient, the court said.

However, the court concluded that, of the various tests for determining material participation, Hailstock satisfied the facts and circumstances test in Reg. Sec. 1.469-5T(a)(7) because of her credible testimony and the substantial amount of money and time devoted to each rental property. Although the court cautioned Hailstock to construct contemporaneous time logs for her future real estate endeavors, it found her detailed and credible testimony to be a reasonable means of proof that she materially participated in her real estate endeavors and could deduct most of her rental losses. The court did disallow losses relating to a property for which Hailstock reported minimal amounts of rental income 2005 and 2006 and no rental income for 2007-2009 and which the City of Cincinnati found to be in violation of housing codes. According to the court, this supported the IRS's contention that the property was not an active rental property.

For a discussion of the passive activity rules with respect to rental properties, see Parker Tax ¶247,120.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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